Bonds Still Aren't Cheap

It’s a long time since we had a bear market in bonds. Some may remember 1994, when Greenspan shocked the market from its complacency with a series of hikes in the Fed Funds rate. Events culminated that year with the bankruptcy of Orange County due to ill-advised bets on continued low rates by its treasurer Robert Citron. Or 1987, when a weak US$ and rising trade deficit led to rising bond yields and ultimately a stock market crash. The economy barely reacted to the turmoil on Wall Street and continued its expansion.

The problem today for bond investors is that, although the value in bonds is somewhat better with higher yields, they’re still not remotely cheap. The FOMC tells you on their website that the equilibrium Fed Funds rate is 4%. They don’t tell you when we’ll get to that level, but a clear consensus of FOMC members expects to begin raising the Fed Funds rate by 2015, two years from now. Even a measured pace of 0.25% per quarter would get short term rates to 4% by 2018. On that basis, a ten year treasury note yielding 2.4%, albeit 0.80% or so better for investors than a few months ago, doesn’t exactly represent compelling value. Personally, I think ten year notes would need to yield 4%, or 2% over inflation, before they’d even be worth considering. The same applies to corporate bonds adjusted up by an appropriate credit spread. The realization that the Fed will, in the foreseeable future, curtail their support of bond prices reveals how little true value they offer once the biggest buyer modifies its interest.

Based on what the FOMC discloses publicly about their rate forecasts – and their forecasts are more important than yours or mine since they can make them happen – I imagine Ben Bernanke must not think bonds represent a particularly good investment for anyone who’s a commercially driven investor. In other words, unless you’re a central bank looking to influence rates or park large reserves somewhere safe, don’t do what I’m doing.

In spite of the equity market’s poor reaction, it’s worth considering that the FOMC’s latest move (or signaled move, since they haven’t actually curtailed their $85 billion a month in purchases) may be well judged. So far since 2008 you’d have to give them credit for pursuing unconventional means boldly. Inflation remains low and economic growth remains positive although unemployment is still high. The Bernanke haters who own gold and gold-related investments on the dubious grounds that some greater fool exists to pay a higher price for a fairly useless, heavy, non-income generating mineral have done even worse than bond investors. As the Irish builder in Fawlty Towers sagely noted to Basil following a botched job, “There’s always someone worse off than yourself, Mr. Fawlty.” To which Fawlty replied, “Well I’d like to meet him then. I could do with a laugh.” So Mr. Bond Buyer, cast your gaze on the Gold Bugs and cheer up.